How Can I Keep More of My Mutual Fund Profits?

Provisions in the tax law allow you to pay lower capital gains taxes on the sale of assets held more than one year. The maximum long-term capital gains tax rate is 20 percent (10 percent for individuals in the 10 or 15 percent tax bracket). Short-term gains — those resulting from the sale of assets held less than one year — are still taxed at your marginal income tax rate.

In addition, for investments acquired starting January 1, 2001, and held for a minimum of five years, capital gains are taxed at a lower rate of 18 percent. For those in the 10 or 15 percent tax bracket, any investment held for a minimum of five years and sold after January 1, 2001, will qualify for lower capital gains taxation at a rate of 8 percent.

This means that if you’ve been buying shares in a stock or mutual fund over the years and are considering selling part of your holdings, your tax liability could be significantly impacted by the timing of your sale.

The main pitfall for most investors is the IRS’s “first-in, first-out” policy. Simply stated, this means the IRS assumes that the first shares you sell are the first shares you purchased. Thus, the first shares in become the first shares out. As a result, if the value of your shares has appreciated, more of the money you receive from the sale will be considered taxable as a capital gain.

Fortunately, there is an alternative. When you place a sell order, instruct your broker or mutual fund transfer agent to sell those shares that you purchased for the highest amount of money. This will reduce the percentage of the proceeds of the sale that can be considered capital gain and is therefore taxable.

In order for this strategy to work, you must specify exactly which shares you are selling and when they were originally purchased. Ask your broker to send you a transaction confirmation that identifies by purchase date the shares you want to trade. This will enable you to minimize your taxable gain and maximize your deductible losses when you fill out your tax return.

In some cases, you may be better off selling the first shares you purchased even if this results in a larger gain. If the first shares are subject to the 20 percent long-term capital gains rate, but the recently purchased shares are subject to a higher, short-term rate, the correct choice may not be obvious. Always consult with a tax professional.

Some transfer agents for no-load mutual funds will not go through the trouble of isolating by purchase date the shares you want to sell. That doesn’t necessarily mean you are stuck with the first-in, first-out computation.

By carefully reviewing your brokerage statements, you can determine which shares you paid the most for. You can then specify exactly which shares you’d like to sell. A word to the wise: Make this request in writing. If the IRS calls the transaction into question, the burden of proof is on you.

Finally, the IRS also allows you to calculate your tax basis by taking the average cost of all your shares. On an appreciating asset, this will result in a lower tax liability than the first-in, first-out rule would dictate.

Be aware, though, that if you elect to average, you must continue to average for any subsequent sales. You don’t have to stick with share identification for future transactions. Either way, you may end up with a lower tax liability from the sale of your shares than the IRS would assume using the first-in, first-out rule.

© 2003 Emerald Publications

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